Options 101.1

The past year I’ve been learning a lot about options and how to use this derivative to create an extra stream of income. It’s a great product but with a lot of conditions. In this post I’ll guide you from the beginning to help you understand and hopefully use this product in your advantage.

What are options?

If any of the used terms are unclear, feel free to scroll to the bottom of this page to find a quick overview of all the terms and their explanation!

Options are contracts with almost always 100 shares as the underlying asset. There are two types of option contracts, puts and calls.

-Buying a call option gives you the right to buy 100 stocks of company ABC on (insert date) for (insert price).
-Selling a call option gives you the obligation to deliver 100 stocks of company ABC on (insert date) for (insert price).

-Buying a put option gives you the right to sell 100 stocks of company ABC on (insert date) for (insert price).
-Selling a put option gives you the obligation to buy 100 stocks of company ABC on (insert date) for (insert price).

Selling options provides you with a premium, the premium is paid by the investor who buys the option. The seller takes on an obligation and gains something in return for it. It works the same as an insurance company when you ask them to insure something for you.

You can sell options ‘naked’ or ‘covered’. Selling naked means that you are speculating on not having to do anything, as you can’t buy any shares and/or don’t have the shares to sell. Covered means that you have the shares in your portfolio or that you have the needed cash in your account.

You can use options to speculate by ‘guessing’ that the strike you agreed upon will not be reached. For example: you take on the obligation to buy 100 shares of Coca-Cola on 15 FEB 2019 for $40 but you’re not interested in owning 100 shares. This means that you hope that on the 15th of February, the share price will be higher than $40 so that the other party will not sell you the shares at $40. This way you speculate on not having to do anything and collecting ‘free’ premium. Much like an everyday insurance company!

What do options look like?

ABC C 15 FEB 2019 100: We have the right to buy 100 shares of ABC until the 15th of February in 2019, for a price of 100 Dollars or Euro’s.
ABC -C FEB 2019 100: We have the obligation to sell 100 shares of ABC until the 15th of February in 2019, for a price of 100 Dollars or Euro’s.

ABC P 15 FEB 2019 100: We have the right to sell 100 shares of ABC until the 15th of February in 2019, for a price of 100 Dollars or Euro’s.
ABC -P 15 FEB 2019 100: We have the obligation to buy 100 shares of ABC until the 15th of February in 2019, for a price of 100 Dollars or Euro’s.

Now it’s only fair to receive a bit of money for the obligation you take on, this is called the option ‘premium’. The person who buys the option (the one who receives the right to sell) pays the premium to the person who sells the same option (the one who has the obligation to buy).

How do we calculate option premium?

  • Time and expectancy value;
  • Intrinsic value.

Time and expectancy value comes down to how much time is left until the contract expires, if more can happen in the meanwhile, you’ll have to pay (or receive if you sell the option) more premium than when the contract finishes tomorrow. Also the volatility of the underlying company, expected dividends, the current interest rates and the price of the underlying company compared to the strike (agreed upon price) of the contract influence the premium price.

The intrinsic value is simply how far the option is ‘in the money’. When you have the right to sell shares at $30 and the company currently trades at $29, the intrinsic value of the option is $1 as you can sell your shares for one dollar more than the market currently pays for those same shares.

You can divide options in the following three categories:

  • In the money;
  • At the money;
  • Out of the money.

If the option you sold expires in the money it will likely be ‘assigned’. This means that the obligation you took on will happen. You will give the other investor his 100 shares (sold call), or you will buy his 100 shares (sold put).

If the same option would be at, or out of the money there is no benefit in using the right to sell shares (as the market gives you the same amount, or more money) or to buy shares (as you can buy them for the same amount or less on the market).

What are the options, with options?

With any option contract, three things can happen at the end of it:

  • Exercise the contract;
  • Let the contract expire worthless;
  • Roll out the contract.

I assume the first two are clear, but ‘Roll out the contract’ probably sounds a bit vague. Basically it means buying back your obligation when you don’t want to get assigned and then selling the same obligation at another date down the road. If you have ABC -P 18 JAN 2019 100, you have the obligation to buy 100 shares for $100 until the 18th of January, if the other investor wants to sell those shares. If the shares of ABC are around $95 in the week of the expiration, you’ll more than likely get assigned. If you don’t want this to happen because you don’t have the cash on hand, or you’re nervous about the market or whatever, you simply buy the same contract to make your position neutral.

Obviously the contract is $5 (obligation to buy at $100, the stock is currently at $95) in the money and it will be more expensive to buy back, you made a loss. But it also means that, that same contract for the next month delivers more money. So buying back your contract provides you with a loss, but if you sell ABC -P 15 FEB 2019 $100 you’ll get more option premium for it as the contract is in the money, and there is still a month left until it expires.

Sell: ABC -P 18 JAN 2019 $100 – Receive $100 in premium.
You have a obligation now, but the share price falls below $100.
Buy back: ABC P 18 JAN 2019 $100 – Pay $300 in premium.
Now your position is neutral, but you lost $200.

Sell: ABC -P 15 FEB 2019 $100 – Receive $500.
You have the same obligation again and for now the loss has been averted. You have another month to wait for the price to go above $100 again so that you don’t have to fulfil your obligation.

This is called, rolling out your option.

Rolling out an option is only possible when you sold the option.

American vs. European style

There are two styles of options, American and European. They work the same, they are noted the same, however the only difference is the ability to exercise the option prematurely. American style is for all the individual names, ETF’s or stocks. European style goes for all the indices. As the owner of the right, so when you bought the call or the put you can decide to use your right prematurely when the option is American style. When you have a right on an index, so European style, you can’t exercise prematurely. At the end of the expiration date, the cash settlement will happen automatically. As an index itself is not deliverable it will always happen in the form of a cash settlement.

So American and European style have NOTHING TO DO with American or European companies.

Margin

When buying options (gaining the rights) you don’t have to use any margin in your investment account. After all, you have a right and this will only be exercised when you say so. The only money you need, is the money to pay the premium to the option seller.

When you sell options however, you’ll use margin. Margin means that your brokerage wants ‘something’ in your account to make sure you’re able to fulfil your obligation(s). Normally this ‘something’ is the cash in your account. Usually you can sign a contract with your broker that will enable margin on your stocks/etf’s/bonds. They will be used as a sort of collateral.

Say you have $50.000 worth of stocks in your account and assume your broker uses a margin percentage of 70%. In this case you have (50.000*0,7 =) $35.000 worth of collateral in your account. Whenever you sell an option, the required margin will be taken from this 35.000.

An important thing to keep in mind with this is that when volatile times or a recession comes around, your stock value will drop and often required margin percentages for options will rise. This means that when you play the game to risky and you’ve used all of the 35.000 for options, this number will go below zero. This is often where your broker will notify you that if you don’t add enough money to your account within X days, they will start selling positions of yours.

When you have 100 stocks of company ABC in your portfolio and you sell a call (obligation to sell 100 shares), you won’t need to use margin as your option is covered. When the option contract gets exercised, you can always fulfil your obligation by simple handing over the 100 shares.

How to generate extra income with your portfolio

The most simple ways to earn extra income on your current portfolio is to do one of the following two things:

A) You sell puts (you take on the obligation to buy) on shares that you’re looking to buy anyway. This way you could buy them with a discount and if you don’t get assigned you can just keep the option premium as extra ‘passive’ income.

B) You sell calls (you take on the obligation to deliver) on shares that you’d be interested in selling. If those contracts get exercised you lock in capital gains, and if the option expires out of the money you keep the option premium as income.

Short Strangle

One of my favourite strategies is the Short Strangle, it means you sell a call and a put on the same stock and you are saying ‘I don’t mind buying 100 shares at $20 and I don’t mind delivering 100 shares at $30’. To do this safely (covered) you need to have a 100 shares of the underlying asset as well as enough money to buy a 100 shares of the underlying asset.

Credits to: https://www.optionsbro.com for this great representation of a short strangle.

Ideally the stock price stays between $20 and $30 so you’ll collect two premiums without having to do anything. Lets look at some examples:

A) The stock is under $20 at the expiration date: you collected two premiums (the call and the put) and you get to keep these. However because the stock ended under $20 you will be obligated to buy 100 shares at the price of $20. The other option (the call with the obligation to sell 100 shares at $30) will expire worthless.

B) The stock is between $20 and $30 at the expiration date: you collected both the premiums and you get to keep them. Because both of your obligations are not in the money you won’t have to do anything and you made profit on both the option contracts.
The options are not in the money because the other party will only sell the shares to you when the market offers less than $20. They will only buy shares from you when the market offers more than $30. Both will not happen when the shares are priced between $20 and $30.

C) The stock is above $30 at the expiration date: you collected both premiums and you get to keep them. However the market offers more than $30 for your shares and so you’ll be obligated to sell your shares for just $30 a share to the other investor. The other option (the put with the obligation to buy 100 shares at $20) will expire worthless.

It can be a very effective strategy if you want to own 1000 shares of stock XYZ, you purchase 500 shares and then you sell 5 puts and calls.

There are way more strategies to use when it comes to options, but I’ll save those for another time.

To read more about strategies I used or trades I did CLICK HERE.

Option vocabulary

  • Call – Right to buy.
  • Put – Right to sell.
  • -/Sold call – Obligation to deliver.
  • -/Sold put – Obligation to purchase.
  • Covered call – You have 100 shares to deliver if you get assigned.
  • Covered put – You have the money to buy 100 shares if you get assigned.
  • Naked call – You don’t have a 100 shares to deliver when you get exercised.
  • Naked put – You don’t have the money to buy a 100 shares if you get exercised.
  • Open buy – You open a position by buying a contract.
  • Open sell – You open a position by selling a contract.
  • Close buy – You close a position by buying a contract.
  • Close sell – You close a position by selling a contract.
  • Margin – When you are selling naked options, your broker will require a margin to be sure you can fulfil your obligation. More often than not, the margin is not required to be all of the money you’d need.
  • Assignment – The option contract gets exercised.
  • Strike – Price point of the option.
  • Rolled – Buying back your sold option to sell it at another date.
  • Intrinsic value – The difference between the strike and the current price of the underlying asset, you can never have negative intrinsic value.
  • Time & Expectancy value – The remaining time in the contract, dividends, volatility, interest rates and the price of the underlying asset are factors. Total option premium – (possible) intrinsic value = Time & Expectancy value.
  • In the money – The option contract contains intrinsic value.
  • At the money – The price of the underlying asset is near the strike.
  • Out of the money – The option contract doesn’t contain intrinsic value.

This is the first part of a extensive option series, I’m planning to create an entire series on the matter. Feedback or suggestions will be appreciated!

Feel free to ask me anything, there are no stupid questions!
Follow @DutchInDepth on Twitter.

To find more information about options CLICK HERE.

For any questions regarding options, leave them down below in the comment section or simply hit me up on any of my social media channels!

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6 Comments

  1. Nice post. I think you explained it well. I’m glad to say I knew most of it already :). That must be a good sign. But I did learn a few new things about intrinsic value and the time and expectancy value.

    For anyone that still doesn’t fully understand options, don’t worry. Options are a tricky thing to learn, but I promise you that after some time it will all start to make sense. Just keep reading and learning about it. And don’t be afraid to ask questions.

    • DutchIndependence

      Hi SD, great to hear that it makes sense. I was slightly afraid it would’ve been too complicated to understand the post.

      Also that is some great advice you have for other people trying to learn more about options. Keep learning and at some point it will make sense to you!

      DI

  2. Ilse

    Very informative! I like the use of examples to make all these terms and strategies a bit more tangible and to make it really ‘click’.

    • DutchIndependence

      Thanks Ilse, happy to hear it was informative and clear!

      Thanks for commenting!

      DI

    • DutchIndependence

      Hi Mr. Groeigeld, thank you for your kind words. Take it slow and learn a lot, but I can highly recommend to use options to boost income on your portfolio.

      Make sure to check back every now and then as I will keep posting about this topic, the Options 101.2 is almost done already! 😉

      DI

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